A Distant Ship’s Smoke on the Horizon

The stock market seems to have become comfortably numb to the economic ills that the COVID contagion has wrought. The recent statistical data provided some measure of how much the economy has suffered, but even as that data has worsened, the stock market seems to be feeling no pain. Clearly, the market is looking beyond current conditions to what the future might bring. Like castaways on a tiny island, the market sees a reason for hope on the horizon and has been celebrating the presumed, impending rescue.

The threat of a widening contagion put a big hurt on the market in March. Actions from Congress and the Fed were the elixir that helped to ease the market’s pain and get it on its feet again. With last week’s advance, the major averages are at or near their recovery highs. Unfortunately, with projected earnings in 2020 and 2021 likely to be less than they were in 2019, the current price levels put the market at an even higher Price/Earnings ratio than it saw at its peak in February. Not only is the market convinced that the ship on the horizon is coming to its rescue, but it also seems to believe that the rescue will come very quickly.

With many states now allowing limited re-openings of some businesses, and with the promise of unlimited fiscal and monetary support, one can reasonably assume that the U.S. economy has bottomed. It’ll likely take a month or two before the economic data shows signs of improvement. And, certainly, the stock market is not going to wait for the data before it prices-in the improving conditions. But, it’s also certainly possible for the market to get a little too optimistic; individual stocks and the market overall could rally to levels that overestimate the speed of the economy’s recovery.

Stock prices are essentially the current composite opinion of the present value of the expected future earnings of the companies. Typically, we can look at recent and current earnings and make reasonable projections for future results. In the midst of the COVID contagion, that process of fudging forward earnings has gotten a lot fudgier. This year, the first and second quarter results probably have very little predictive value in projecting a company’s earnings for later this year and next year. Most companies will probably report suddenly lower earnings or losses, but those declines should be temporary. Many fewer companies, specifically those which have reaped sudden increases in their businesses as a result of the shelter-at-home mandates, will probably record suddenly inflated results. But those improvements are likely temporary as well.

Projections of earnings in the quarters and years ahead are always based on unknown future conditions. The unique problem now is that possible conditions in the months ahead cover such a very wide range of potential outcomes. When will large-scale virus testing become available? When will a vaccine be widely available? What will happen if the number of infections in the U.S. begins to ramp up again later this year? Is the rescue ship on the horizon getting closer or further away?

Six weeks ago I wrote, “If there’s a silver lining in the COVID-19 cloud, it may be that times of crisis tend to accelerate the adoption of new technologies. How many families who were not planning to subscribe to streaming services, to shop online, have groceries or meals delivered or make virtual payments on their cell phones, will adopt one or more of these services in the months ahead? Many firms offering these technologies are relatively young companies; the one’s that can survive the economic downturn could see a big increase in their customer bases.” The stocks that have been the stars of the rebound rally are mostly those internet, tech and social networking companies that have been immune to the virus.

The major averages made their lows for the week in the opening minutes of trading on Monday. They trended generally northward from there, reaching their highs of the week in a last-hour surge in Friday’s session. The NASDAQ Composite Index (COMP) was the big winner for the week (+6.0%) thanks largely to strong gains in several mega-cap tech and internet companies that dominate the index. A prime example of that dominance came last Wednesday, the worst day of the week for most of the indices. Like the other indices, COMP finished near its low, but gained 0.51% for the day. It was that handful of mega-cap stocks, which continued to trend higher, that enabled COMP to outperform. The standard, capitalization-weighted S&P 500 Index (SPX) lost 0.70% on the day and the equal-weighted S&P (SPXEW) fell 1.37%.

For the week, SPX gained 3 ½% while the Dow Jones Industrial Average (DJIA) gained a little over 2 ½%. Where COMP climbed to a new recovery high, neither DJIA nor SPX were able to get back to their highs of the previous week. DJIA had its narrowest range week since late-February. For the past two weeks, SPX has had roughly the same range, and both were the narrowest since late-February. The continuing decline in volatility was also evident in the CBOE Volatility Index (VIX), which ended last week at its lowest level in more than two months.

SPX ended last week near 2930. That’s less than 1% below the previous week’s high and less than 3% below the 3000 level and its 200-day moving average. Sustained trading above 3000 would be an impressive sign of strength but would likely require some very good news on the contagion and continued giddy optimism in the markets. Last Monday’s low was just below 2900. Falling back below that level would be a short-term negative. The real danger level for SPX is in the 2727 – 2730 range. That’s the area of the April 21st low and the index’s 50-day moving average. Sustained trading below that level would likely be a signal that the rebound rally has run its course.

The flow of earnings reports continues this week, though at a more subdued pace. I suspect we’re in an environment in which chasing rallies on good news will be less profitable than buying pullbacks on bad news.

The market has clearly lapsed into a comfortably numb state with respect to the recent horrific economic reports. We’ll get a bunch more this week, when all the potentially market-moving data comes on Thursday and Friday.